I’m a Professor of Economics at University College, Dublin. I have a PhD in economics from MIT. I worked for the Federal Reserve Board from 1996 to 2002, regularly briefing Alan Greenspan and working on the FOMC's macroeconomic forecast. From 2002 to 2007, I worked for the Central Bank Ireland and attended many meetings at the European Central Bank.
My research on macroeconomic issues has been published in many of the world's leading economics journals. These days, in addition to my research, I teach classes, supervise PhD students and comment on macroeconomic and banking issues with a particular focus on Europe. I’m also a member of the European Parliament Economic and Monetary Affairs Committee’s expert panel of advisers on monetary policy. You can find out more about me at www.karlwhelan.com and follow me on Twitter at @WhelanKarl.

Time For ECB To Agree A New Plan For Cyprus

After dominating global headlines in March, developments in Cyprus have received little attention of late. The situation there, however, remains extremely serious and still has the potential to destabilize the euro area. Last week, the Cypriot President, Nicos Anastasiades sent a detailed letter to the EU institutions (Commission, Council, ECB) and the IMF detailing a number of problems with the current plan and requesting changes.

People queue up outside a Laiki bank branch in the Cypriot capital, Nicosia, on March 28, 2013, as they wait for the bank to open after an unprecedented 12-day lockdown. (Image credit: AFP/Getty Images via @daylife)

Though Anastasiades himself must take some of the blame for the events in March (he should never have agreed to the original plan to hit all deposit holders) his letter contains a number of important points which have been generally over-looked. He is correct that Cyprus was badly affected by the sovereign default in Greece and yet Greek depositors with the Cypriot banks were “ring-fenced” when the Cypriot banks failed. The Cyprus package badly failed the sniff test for fairness.

More important are his points about Emergency Liquidity Assistance (ELA) and his request to re-work this part of the plan should be agreed to. There is a lot of confusion about ELA, so I’ll try to spell out the issues here in detail.

While news articles generally discuss the idea of the ECB lending to banks, in fact the ECB itself doesn’t make these loans. Instead, the National Central Banks (NCBs) do all the lending according to criteria set out by the ECB Governing Council. Most of this lending takes the form of repurchase agreements in which a bank temporarily provides assets from an agreed list of “eligible collateral” in exchange for a loan.

In some cases, however, banks run out of eligible collateral but still request loans. Most central banks in the Eurosystem have long-standing powers to provide what we now call ELA in these circumstances. However, Article 14 of the ECB statute gives the ECB Governing Council the power to intervene and prevent any program that it believes interferes with its monetary policy. For this reason, the existence of ELA programs in the Eurosystem as well as their terms and conditions are ultimately decided by the ECB Governing Council.

Problems with Cyprus’s banks had been rumbling for a long time before they came to the world’s attention in March this year. Having invested heavily in Greek sovereign bonds, the Cypriot banks were always going to be in trouble after the Greek debt restructuring. However, the Cypriot government and the international policy agencies failed to address the situation quickly, instead engaging in long and slow negotiations over the conditions for international assistance to Cyprus.

Over the course of 2012, as deposits declined and its Greek bonds were defaulted on, the Cypriot banks became reliant on ELA. (You can see the monthly increases in the category “Other claims on euro area credit institutions denominated in euro” in the Central Bank of Cyprus balance sheets published here.) Even though these banks were clearly insolvent and there were could be problems with these ELA loans being repaid, the ECB approved these loans.

Then, in March 2013, the ECB played a crucial role in forcing losses on depositors in Cypriot banks by insisting there had to be creditor write-downs (meaning deposit haircuts) for ELA to continue to be provided. While depositors in Laiki bank (which had run up €9 billion in ELA – over half of Cyprus’s GDP) suffered huge losses, the ECB insisted that the ELA be paid back in full.

While Laiki is being wound up, its ELA obligation is being transferred to the other main bank, Bank of Cyrus, which now has an enormous €11 billion ELA obligation. While this is supposed to have been facilitated by the transfer of Laiki’s supposedly “good assets” to Bank of Cyprus, President Anastasiades’s letter makes it clear that a large amount of BoC’s assets are now pledged as collateral against the ELA, that the bank has limited ability to obtain further ELA and is facing a severe liquidity crunch. In this situation, it is extremely unlikely that capital controls can be lifted or any semblance of normality restored to Cyprus’s economy.

Before considering the options in relation to the ELA, a few points are worth clarifying.

First, some of the commentary on this issue focuses on the idea that “the ECB wants its money back”, apparently based on the belief that the ECB in Frankfurt loaned this money to Bank of Cyprus. This is not the case. The loan was made by the Central Bank of Cyprus.

Second, it is also not the case that a failure to repay the ELA by Bank of Cyprus would lead to losses for the rest of the Eurosystem. There is an implicit agreement in place for regular Eurosystem operations, backed by eligible collateral, that losses will be shared among the members of the system according to their ECB capital key. However, this is not the case for ELA. Any loss would fall solely on the Central Bank of Cyprus.

Third, while the loss of its ELA asset would result in the Central Bank of Cyprus have assets being less than its liabilities, there is no legal requirement that central banks in the Eurosystem have assets greater than their (often notional) liabilities. See, for instance, this statement on the matter from the Czech central bank.

So what’s the issue? Why not just write off the ELA and let Cyprus recover? The answer may be familiar to those of you who followed the sad tale of Anglo Irish Bank. A decision to issue ELA to it and then unilaterally allow it to be written it off to save the state spending money recapitalising a bank could be considered “monetary financing” according to Article 123 of the European Treaty.

The recent re-working of Ireland’s ELA thus provides a precedent for how to deal with Laiki and Bank of Cyprus’s ELA. Place the ELA in a separate institution, have the institution default on its ELA and then provide the Central Bank of Cyprus with very long term government bonds as compensation, subject to the agreement that sells these bonds gradually over time to the private sector. If this is legal in Ireland, then it is legal in Cyprus. And indeed, this is one of the options listed in President Anastasiades’s letter.

The ECB’s Governing Council should acknowledge its own mistake in sanctioning the creation of money to be loaned to insolvent banks. Council members should also understand that, beyond the obvious arguments related to the unfairness of the current Cypriot deal, it is in the wider European interest to place Bank of Cyprus back on a stable footing and to lift the capital controls in Cyprus. Failure to do this may have consequences that will rebound elsewhere. Are the ECB keen to have people elsewhere in Europe questioning the state of their banks and wondering whether they will also end up losing their money and having most of the rest frozen?

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